What is Capital Gains?

When you sell a capital asset, such as investments, business interests or certain property, for more than its tax basis, the difference is a capital gain. If you sell for less, it is a capital loss.

Short-term vs long-term

• Short-term: assets held one year or less; generally taxed at ordinary income rates
• Long-term: assets held more than one year; generally taxed at lower long-term capital gain rates

The IRS explains holding periods and rates in Topic 409, Capital gains and losses.

Business assets are different

Many business assets are not capital assets in the strict sense. Inventory produces ordinary income. Depreciable property and real property used in a business, held more than one year, are generally Section 1231 property, reported on Form 4797. Net Section 1231 gains can be treated as long-term capital gains, but part of the gain may be ordinary because of depreciation recapture. See the Instructions for Form 4797.

Selling a business

The sale of a business is usually treated as a sale of its individual assets, with the price allocated among them. Different assets produce different types of gain. Buyers and sellers of a business generally report the allocation on Form 8594.

Capital losses

Capital losses offset capital gains. Individuals can deduct a limited amount of net capital loss against other income each year and carry the rest forward; Topic 409 gives the limit.

Recordkeeping

Basis records are essential: purchase documents, improvement records and depreciation schedules. See the fixed asset register and our tax services.

Related terms

• Assets: Assets are resources a business owns or controls that are expected to provide future economic benefit.
• Tax Basis: Tax basis is the amount the tax law treats as your investment in property, used to figure depreciation and gain or loss.
• Ordinary and Necessary Expenses: Ordinary and necessary is the basic test a business expense must meet to be deductible.
• Depreciation Recapture: Depreciation recapture is the portion of gain on the sale of a depreciated asset that is taxed as ordinary income because of earlier depreciation deductions.

Browse more definitions in the small business glossary.